Question

3. Consider a small country, Neverland trading with the rest of the world in perfect capital markets. Suppose Neverland has a floating exchange rate. Your CEO, Capt. Hook needs your help-please discuss what is the impact of each of the following events on the exchange rate for the Neverland Doubloons (ND). (All you must do is evaluate what happens to the currency and why).

a) The governor of the Central Bank of Neverland, Ms. Tinker Bell raises domestic interest rates, while world interest rates remain constant. (1 pt)

b) Ms. Tinker Bell also announced today that Neverland’s economy was the fastest growing economy (GDP growth) in the world, stemming from a large current account surplus. (1 pt)

c) Your CEO, Capt. Hook strongly believes that in the long run, the ND will depreciate if Ms. Tinker Bell maintains this higher interest rate for a very long time. Do you agree? (1 pt) Suppose Neverland had a fixed exchange rate, and is committed to keeping it fixed through open market operations (i.e. the central bank buying and selling currency to keep it fixed.)

d) If Ms. Tinker Bell raised domestic interest rates now, what will happen to the exchange rate? What

should your CEO, Capt. Hook expect Ms. Tinker Bell to do? Will it impact your company’s operations in Neverland? (2 pts)

Answer 1

Ans a - If Neverland increases interest rates and world interest rate remains constant, this will attract investments opportunity in Neverland, global investors are interested to invest in Neverland to obtain maximum return.This appreciate the value of ND currency and other currencies value get depreciate.So exchange rate will rise.

Ans B- If Neverland economy was fastest growing economy in the world which increase domestic demand as compare to supply. To meet increased demand there is need of import in Neverland.Due to increased import results in increase demand of other curriences. Because of this there is decrease in value of Neverland currency and other currencies value increase.So exchange rate decrease.

Ans c - In long run high intrest rate rise exchange rate but due to this export falls.Because of low export demand falls and Value of ND gets down. So in long run ND gets depreciate.

Ans D - If domestic intrest rate raised now it will increase exchange rate.CEO capt expect to keep it constant. Yes it impact companys operation as more capital is required to carry business.